The Effect of a Federal DBCFT on U.S. States, and Vice-Versa: A Compromise Proposal
Last Friday I attended a forum on international tax reform, hosted by Georgetown’s Institute for International Economic Law. As you might expect, one focus of the discussion was on Republican plans for the so-called “DBCFT,” or the destination-based cash-flow tax. (I pronounce it “Dub Foot,” but at the conference its key architect proclaimed that the acronym was “unpronounceable.”) There are several good explainers available on-line. For our purposes, here’s what you need to know: repeal the U.S. corporate income tax, replace it with a VAT that also gives a deduction for wages paid by the selling firm.
Strikingly to me, no one seems to have given any real thought to what would happen to U.S. state revenue systems under the reform. Michael Graetz’s otherwise comprehensive master exercise in concern-trolling (“not saying I’m against it, but have you guys considered these 27 possible dire side-effects?”) has one half-filled slide on state impact, and it’s basically just a .gif of a guy shrugging.
I see two big problems for states. First, many states derive a fair bit of revenue from their corporate income taxes (the median is around 5%; high-end states like Illinois, Tennessee and California run from 8 to 10%, and New Hampshire is off the charts at 25%).
It is hard to see how state corporate-income taxes are sustainable in a world with no federal corporate tax. The incremental filing and compliance burdens would, of course, increase massively. Businesses would justifiably complain about the great difficulty of trying to plan simultaneously for the DBCFT and state taxes. Moreover, the continuing existence of state corporate taxes would undermine many of the incentive effects (in terms of things like income-shifting and debt/equity ratios) that the move to DBCFT is supposed to resolve, generating likely political pressure from the feds. And, of course, the federal government would no longer be back-stopping state corporate-tax enforcement, which some evidence (paywall) suggests is important to the viability of the state systems.
Another concern is that the current design of the DBCFT might open large tax sheltering opportunities for state income-tax payers. Potentially, in a DBCFT world wealth individuals could easily stow investments in out-of-state corporations, where they will accumulate untaxed until distributed (and not even then, if distributed to the next generation): in essence, a kind of unlimited Roth IRA.
Here’s how I think that would work. While the exact treatment of corporate portfolio investments isn’t totally clear to me, at a minimum the DBCFT exempts the normal return to capital for operating firms. States can’t impose collection or reporting obligations on corporations that lack “substantial nexus” with the state. So a California taxpayer could contribute all her investments to a Delaware corporation with no other ties to California, secure in knowing that California likely could not readily detect her investment earnings. What prevents this technique now (if anything) is the federal corporate income tax, which imposes a similar rate on investment earnings to that taxpayer would herself pay in combined state & federal capital gains. DBCFT architects have not said whether they would retain the excess business holdings tax; if enforced vigorously, that would reduce the sheltering concern.
Some might say that states could resolve at least the first problem by adopting their own DBCFT, but that route may have constitutional problems. To a lawyer, the DBCFT looks like something of a hybrid between a sales tax and a corporate income tax, in the sense that the corporation files a return, deducts wages, and so on. In Quill Corp., the U.S. Supreme Court ruled that states cannot impose sales or use-tax collection obligations on firms unless those firms have a “physical presence” in the state. It is unclear whether this same rule extends to other forms of tax. So Quill would potentially prevent states from collecting the “border adjustment” tax (i.e., the VAT on imports) from firms that sold via the internet and shipped from out of state. Similarly, states could not easily respond to the revenue lost via their corporate and individual income taxes by raising sales tax rates, as that would likely put pressure on retailers to relocate (although see this nice discussion about other tools for enforcing use taxes by Adam Thimmesch).
Readers may know that Congress has been considering legislation that would in effect overturn Quill. That’s possible because Quill rests on the dormant commerce clause, and Congress can authorize DCC violations.
Here, then, is my proposal: if Congress adopts the DBCFT, it should also adopt legislation authorizing state-level border adjustments, either through me-too DBCFT’s or retail sales taxes. That would hold states largely fiscally harmless, and give them incentives to switch away from the costly and distortive alternative of maintaining their own corporate income taxes.